Overtrading and

Overcapitalization in working
capital
Risks
• There are two main risks of not monitoring working capital:
• Over-capitalization
• Overtrading
• Overtrading in working capital refers to a situation where a company
operates with insufficient working capital, often caused by excessive
sales growth without a corresponding increase in available capital.
• Sometimes it can also be referred as under capitalization.
Overtrading
• Overtrading refers to a state when a business is carrying out transactions
at a high speed which cannot be supported by its working capital.
• This means that the increased number of transactions are putting
pressure on the cash flow of the business , thus giving rise to risks of
insolvency.
• The problem of overtrading is very common to businesses , but it affects
more to-:
• Startups
• SME’s
• Rapidly expanding businesses
Inventory bought on credit Sold on credit Cash is received from Debtors

Suppliers paid

Cash
Salary paid

Rent paid
Inventory bought on credit Sold on credit Cash is received from Debtors

Suppliers paid

Cash
Salary paid

OverRaise
draft limit
Rent paid overdraft
Reached
Inventory bought on credit Sold on credit Cash is received from Debtors

Suppliers paid

Cash
Salary paid

Over draft limit

Rent paid
Reached
Example- Retail Store
• Imagine a small retail clothing store that experiences rapid growth in customer
demand. The store starts offering more product varieties and opens new
branches in different locations to meet the increasing demand. However, this
expansion requires higher inventory levels, additional staff, and increased
marketing efforts.
• Overtrading occurs when the store's sales growth outpaces its ability to finance
these operational needs. Despite the increased sales, the store struggles to
manage its inventory efficiently, resulting in excess stock and tying up cash.
• The costs associated with hiring and training new staff, along with increased rent
and marketing expenses, strain the store's cash flow. As a result, the store may
face liquidity problems and challenges in meeting its financial obligations.
Tech Startup Example:
• Consider a tech startup that develops a popular mobile application. The app
gains rapid traction and user adoption, leading to exponential growth in user
numbers. The startup's management decides to aggressively scale up the
user base without fully considering the impact on the company's working
capital.
• As user growth accelerates, the company needs to invest in server
infrastructure, customer support, and marketing campaigns to sustain its
growth trajectory. However, the costs associated with these efforts start to
outpace the revenue generated from user acquisitions. This imbalance leads
to a situation where the company is spending more on expansion than it can
afford, causing working capital constraints and potential cash flow issues.
Impact of Overtrading
• Increase in credit sales
• More cash or credit needed
• Suppliers stop inventory on credit
• Overdraft limit reached
• Some credit sales coming as cash
• No inventory
Overtrading
• Is often associated with a rapid increase in turnover.
• Investment in working capital does not match the increase in sales.
• Could be indicated by a deterioration in inventory days.
• Possibly because of stockpiling in anticipation of a further increase in turnover,
leading to an increase in operating costs.
• Could also be indicated by deterioration in receivables days, possibly due to a
relaxation of credit terms.
• As the liquidity problem associated with overtrading deepens, the overtrading
company increases its reliance on short-term sources of finance, including
overdraft, trade payables and leasing.
• Can also be indicated by decreases in the current ratio and the quick ratio.
Financial indicators of Overtrading
• Rapid increase in sales
• Gradual increase in current assets (Receivables increase due to inc. in
sales)
• Rapid increase in current liabilities (Payables and bank overdraft
increase)
• Decline in current and quick ratio (Current liabilities more than CA)
Overcoming Overtrading
• Increasing the long term capital of the company
• Stopping rapid expansion of sales till company stabilizes (Focus on
cash sales)
• Increasing collection of receivables
• Reducing inventory
• Creating credit control measures
• Shorting the manufacturing cycle
• Cutting cost and improving efficiency
For example-:
Year 1 Year 2 Year 3
Sales 100 200 300
Inventory 20 40 60
Receivables 30 60 90
Cash 10 (40) (70)
Payables (10) (30) (50)
Current ratio= CA/CL 60/10=6 60/30=2 80/50=1.6
Quick ratio= QA/CL 40/10=4 20/30=0.67 20/50=0.4
Over-capitalization
• Over-capitalization means that an entity has an excess of working
capital.
• Entities that carry excessive inventories, receivables and cash with
few payables have over- invested in current assets.
• This presents an opportunity cost since such resources could be used
to generate returns elsewhere in the entity.
Causes of Overcapitalization
• Overestimation: A company raises capital in expectation of future earnings when this expectation is
misplaced, the company feels it needs to raise a greater amount of capital to fund such earnings.
Therefore the company raises a greater amount of funds than required to generate an actual amount
of profits.
• Timing Effect: When the company starts off in the period where the prices are very high, its
estimation of cost of a revenue-generating asset is higher and therefore it raises more capital,
however by the time the actual CAPex is required, the prices have reduced and the capital
requirement has reduced.
• Estimation of Marketing Expense: Companies may feel that they need to access different marketing
channels and make an assumption of the required funds, however, the actual promotion required
while the capital raised for the same is way too much as compared to the requirement
• Unusually Lower Depreciation Rate: Overcapitalization also implies that the valuation of assets is
higher than the intrinsic value of these assets. One of the reasons for the same could be charging
unusually lower depreciation rate that would lead to depreciating lesser and thereby showing a higher
value of assets
Effects of Overcapitalization
• Interest Burden: If a lot of debt capital has been raised, then the interest burden is also very high
because debt interest needs to be paid even if the company incurs losses, let alone only breaking even.
Therefore the return requirement becomes excessive in comparison to the profits earned by the
company.
• Vicious Circle of Under Profitability: Due to low profitability, the amount of dividend distribution is low
because whatever little profits remain after paying off the interest liability goes to retained earnings.
Even so the retained earnings accumulation is also not very high to invest in the available growth
opportunities and therefore the company enters into the vicious circle of under profitability as without
investing into growth opportunities it is unable to increase profitability and faces this same issue year
after year.
• Losses: After being able to meet the interest burden for some years, the company enters into losses as
the interest burden becomes unsustainable and this is when the company reaches its rock bottom
• Collapse & Shutdown: Ultimately after the assets are reduced to almost nothing the company collapses
and goes bankrupt without having enough to pay off the debt, let alone paying anything to the equity
shareholders and the only option left is to shut down the business.
Difference between Overcapitalization and
Overtrading
• Meaning: Overtrading is the excessive aggressive expansion of
operations of the company without raising sufficient capital to sustain
such expansions. Overcapitalization is the excessive capital raising,
without having any good expansion, growth or scale-up plan
• Working capital: Overcapitalization leads to excessive availability of
working capital while overtrading leads to the completely opposite
situation.
• Impact: Overcapitalization can lead to the complete collapse of the
company and its operations, overtrading would only lead to
downsizing but not complete collapse or shutdown.
Advantages and Disadvantages
• Advantages
• Investment capital: If the company is prudent it can invest the capital and earn the return at least as much as to cover the return requirement if not
greater than that. This can help the company in breaking the vicious circle of unsustainable returns so that it can steer itself to a growth trajectory.
• Flexibility: Excess capital gives the company immediate funding for CAPex when required and thereby not delay such investment and help the
company in catering to urgent requirements of changing markets such as the production of an improved product, requiring advanced plant and
machinery.
• Disadvantages
• Unsustainable: Interest burden increases beyond the sustainable levels leading to excessive losses, collapse, bankruptcy or shutdown and investors
losing a lot of their invested money as in most cases the amount of money available for paying off the interest burden is not sufficient, let alone
leaving anything for the equity shareholders
• Declining ROE: Due to excessive interest, the amount of net income available for equity investors is very low leading to very low return on equity
and forcing the investors to sell their shares as and when possible and in turn leading to falling market prices.
• Triggers Accounting Fraud: Too much pressure to maintain the market value leads to company cooking up the books of accounts by undertaking
accounting malpractices such as recognizing excessive revenues than warranted or, taking a lot of liabilities off the balance sheet through SPVs.
However, these may cause some short term relief but the company lacking substance ultimately falls apart.
• Bubble in Valuation: Accounting malpractices make the financials look a lot better than they actually are and this leads to a surge in the security
prices, however, this is only a bubble as the intrinsic value of the company is much lower and when such bubble bursts, it causes huge losses in
shareholder’s wealth
• Need to Refinance: When the interest rate in the market is lower, it is beneficial to raise capital but if there is overcapitalization, the company loses
the opportunity of raising it at a cheaper interest rate or get stuck with paying higher interest rate until and unless it refinances the capital.
Check working capital to sales ratio
• https://
www.smart-investing.in/financial-ratios.php?Company=ADANI+ENTER
PRISES+LTD&p=Working+Capital%2FSales
• https://
www.smart-investing.in/balance-sheet.php?Company=ADANI+ENTER
PRISES+LTD

• Is Adani doing overtrading or overcapitalization in last 4-5 years?

• Check Net sales increase percentage and Total of current assets
increase percentage
Conclusion
• Overcapitalization is the practice of raising too much capital than
required to produce the level of profit that the company is producing
currently and also unjustified with the current level of revenue-
generating assets and future expansion plans. This causes a high cost
of the capital burden when such capital is raised through debt and
even when raised through equity, it causes a fall in investor
confidence if the return on equity is consistently low.